The very basic premise of investing is the idea of finding companies that trade below their intrinsic value, or the value that the company is truly worth. The goal is to buy cheap and make money when a company is valued appropriately. This premise carries across all facets of investing in any asset class and nearly all facets of life (to say all would be a strong argument, and one that would land your humble authors in very hot water). The market is currently telling us a story about value and valuations, and we must put our ear against the wall and listen.
In our view, the S&P 500 is largely overvalued right now, due primarily to the performance of the top few holdings. As the most popular and widely accepted gauge of the U.S. large-cap equity market, the S&P 500’s current price-to-earnings (P/E) ratio is approximately 25x, which makes us believe that the index, and large-cap stocks in general, will underperform should this multiple revert to its lower mean. If the large-cap market does not demonstrate sufficient earnings expansion (with top-line growth), we could see a period of multiple contraction. This would suppress stock prices, drive the aforementioned P/E ratio lower, and reduce investor returns. This possibility leads to the question: “If not large-cap, is it small-cap’s time to shine?”
From a historical standpoint, post-recession markets have consistently been a boon for small company performance for several reasons. Primarily, the threat of a recession pushes many investors out of the riskier and less liquid small-cap environment and into the more dependable sector of the large and mega-cap companies like Tesla, Coca-Cola, and Alphabet. Hedging themselves against economic downturn, investors inadvertently drive down small-cap prices. This results in a vast undervaluation of the small-cap space as a whole—a space that investors flock back to at the prospect of economic recovery. With the majority of Wall Street projecting the Federal Reserve to halt interest rate hikes (and some even predicting rate cuts in 2024) the market is starting to price in this undervaluation in small-cap. The chart below shows this post-recession small-cap outperformance relative to large-cap counterparts. Areas highlighted in gray represent recessions:
Source: Federal Reserve Bank of St. Louis
Similarly, if we look at the small-cap relative P/E multiple (the small-cap P/E divided by the large-cap P/E) we notice that on a relative P/E basis, small-caps are near the cheapest level (lowest relative multiple) that they have been in years:
Source: Bloomberg/BCIS
To supplement this shift in sentiment out of large-cap equities, the fixed income market has been on a tear. 10-year Treasury yields have been treading water around their highest point in 15 years, all but forcing the hands of investors into the bond market. The low-risk nature of bonds combined with their current elevated yields means that the overvalued large-cap equities are less and less attractive. The most favorable yield environment in over a decade has caused some investors to reallocate funds out of equities and into fixed-income; as this has occurred, investors are also asking the question that was posed at the beginning of this piece: Are small-cap equities going to benefit from a further sentiment rotation, all in the context of a normalizing bond market? The following graph evidences the relationship between small-cap stocks and ten-year Treasury yields. We note that the relationship has changed as equities dropped in 2022 and yields rose; though this was due, in part, because of a significant rise in inflation and the Federal Reserve’s reaction to it.
Source: Federal Reserve Bank of St. Louis
Considering the dichotomy in valuations between large and small-cap, combined with investors’ search for yield in the bond market, it is not unreasonable to predict that the small-cap space is approaching its era in the sun. Looking even further down the line, the inevitable rate cuts that the Fed will enact can serve as an additional tailwind for the small-cap space, lowering the cost of borrowing—a historic driver of small-cap performance. These factors are becoming more and more prevalent, seeing small-cap become the “talk of the town.” Investor sentiment is noticeably changing. While we are paying close attention to the small-cap space, we reiterate our position noted in our recent piece, “Equity Valuations”, and posit that investing in small-caps might be a bit premature as they tend to perform well coming out of the down cycle, which, to us, seems to remain on the horizon; if an investor is underweight small-cap stocks, however, they may want to consider increasing exposure to a more neutral position.
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